A push for covered bond legislation in Japan has been spurred in part by a desire to keep up with developments elsewhere, but its goal contrasts with that of many other countries, according to a banker familiar with the initiative.

Japan has yet to join the ranks of covered bond jurisdictions, with Shinsei Bank having in 2008 aborted a structured, mortgage backed deal on account of the financial crisis and no issuance having been attempted since.

Now the government-owned Development Bank of Japan (DBJ) is spearheading a push for covered bond legislation in Japan. It is leading a study group that on 7 July published a report setting out a range of considerations raised by its members – representatives from major banks, securities firms, rating agencies and the Bank of Japan; academics, lawyers, and institutional investors.

Yukio Egawa, chief strategist, head of research division at Shinsei Securities in Tokyo and a member of the study group, told The Covered Bond Report that covered bond legislation has only recently become the focus of market participants’ efforts, and that DBJ has been leading the initiative as it considers ways to diversify its funding sources.

“Another reason for the timing of these efforts is the spreading of covered bond legal frameworks across the world, including in Australia, Canada, Korea and other non-European nations,” he said. “If the trend continues and we do not introduce our own framework then Japanese institutions will be at a disadvantage from a competitive viewpoint compared with European and North American institutions.”

But while developments in new jurisdictions have tended towards mortgage finance, Japanese market participants are eyeing the asset class in the first instance primarily as a tool to raise medium to long term funding for public finance, private finance initiative (PFI), social infrastructure and industrial lending.

“It is very unlikely that covered bonds will be used for housing finance (residential mortgages) for the time being,” said Egawa. “Public finance, PFI, loans to railway and other infrastructures are more likely to form cover pool collateral.”

Egawa contrasted the situation in Japan with debates in other fledgling jurisdictions.

“People in North America, Australia and Korea are considering covered bonds as an alternative to mortgage securitisation,” he said. “We don’t look at it this way. Instead, we see covered bonds as an alternative to bank debentures and as a tool to provide funding to the industrial sector and local governments.”

He identified two reasons for the public sector focus: as the main driver behind the initiative, DBJ, does not lend to consumers; and financing of residential mortgages in Japan is generally well provided for by the Japan Housing Finance Agency, which purchases fixed rate mortgages from originators and securitises them.

Breadth of legislation could influence timing

According to Egawa, covered bond proponents are aiming for legislation to be introduced within the first half of next year, and that the first issuance – initially domestic – would also take place in 2012.

The ease, or otherwise, with which legislation might receive political approval could depend on the scope of the proposed framework and how it can be squared with concerns about structural subordination.

Yukio Egawa

“If the legislation limits the number of eligible issuers, in an extreme case only to DBJ or to DBJ plus the three largest private banks, then it may not be that difficult to pass legislation,” said Egawa. “But if we try to expand the scope of the law it may take more time and effort to persuade the banking regulators.”

A housing finance specialist in Japan told The Covered Bond Report that there seem to be three options for enacting covered bond legislation in Japan: amending the law governing DBJ, amending the banking act or creating a new covered bond law. The latter two would face significant legal debate and there would be pressure on the covered bond proponents to justify the changes, he added.

He suggested that DBJ may refer to the damage caused by March’s powerful earthquake and the subsequent need for reconstruction and funding thereof as one aspect justifying the introduction of a covered bond framework in the country.

According to Egawa the study group has already envisaged ways in which covered bond issuance could be structured to avoid a conflict with Japan’s existing bankruptcy laws, under which deposit taking banks can be placed under legal bankruptcy procedures.

“A very simple structure like the Pfandbrief may not make it easy to achieve bankruptcy remoteness of the cover pool without substantially amending the bankruptcy laws,” said Egawa. “But if a structure is used where an SPV acts as guarantor, like in Italy, then it is easy to transfer the cover pool to the SPV even if the issuer is in bankruptcy.”

Such a structure would also circumvent negative pledge covenants attached to Japanese banks’ outstanding unsecured debt, he added.

Also under discussion are the maturities the study group envisages the first Japanese covered bonds could feature, which, at 10 years or longer, would be quite different from the average tenor of recent dollar and euro benchmark supply.

“The terms of social infrastructure, PFI and local government loans, which we are looking at covered bonds financing, tend to have very long maturities, of 20 years or more,” said Egawa. “In addition both private sector banks and DBJ have been able to raise funding of up to 10 years at very tight credit spreads in the unsecured market.”

It is not clear what the next steps are after the study group published its report earlier this month. Egawa said that the group is agreed on the need for a legal framework and standardisation, but that many points are still open as various alternatives are pursued.

“Further discussions will focus on moving closer to actual legislation, so it may be that they become very technical,” he said.